If you look at a list of stocks with the highest nominal dividend yields, you’ll see that many of them are arithmetic freaks.
Some stocks paid a special dividend last year and won’t do so again. Others are about to cut their dividends or are paying dividends out of capital rather than income.
It’s only as you go down the dividend list that you begin to find stocks in which a sensible person would invest – and that leads us to a crucial question: Is there such a thing as a yield “cutoff”?
That is, can we define a specific yield below which dividends can usually be trusted and above which they can’t?
In today’s low-yield, inflated markets, that cutoff may be lower than you think…
In fact, it’s about 6%. That’s a pretty low threshold, especially considering that the front-runners on Nasdaq’s list of the highest dividend payers all have indicated yields above 40%.
Of course, while such yields look exciting, the dividends of these small firms merely represent a return of capital.
The top one, UBS ETRACS Monthly Pay 2x Leveraged Wells Fargo MLP Ex-Energy ETN (LMLP), is currently paying monthly dividends of $0.90, effectively cannibalizing itself. The second, New Germany Fund, Inc. (GF), is a closed-end fund paying out large capital gains, and the third, Swiss Helvetia Fund. Inc. (SWZ), is a Swiss closed-end fund that’s also paying out its large 2014 capital gains.
Now, there’s nothing wrong with an investment that makes you a 40% return in a year, even if you have to pay taxes on the distribution. But in these cases, the distribution is capital gains, not income, and the outcome is highly unlikely to be repeated in years to come.
Similarly, fallen angels often have very high nominal dividend yields that aren’t likely to last.
SandRidge Permian Trust (PER), for example, is an oil and gas MLP that has fallen on hard times and has seen its share price halved since last August. Since its latest dividend was based on the fourth quarter of 2014 – and reflects the high earnings from having sold oil forward at high prices – its dividend yield is currently a tidy 38%. Alas, that dividend is unlikely to continue once its hedges run out.
Chesapeake Granite Wash Trust (CHKR) similarly yields 29%, but it won’t once the new earnings come in.
Slim Pickings for Yield
At the 12% level, you get entities like Eagle Point Credit Company (ECC), an investment company that buys equity and junior debt in collateralized loan obligation packages. ECC has announced that it will pay a $0.60-per-quarter dividend, giving it a 12% yield on its October IPO price of $20, or about 11.5% on its current price.
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As you can imagine, the problem here is that these junior tranches carry a much higher credit risk than the loans themselves, so at some point, ECC is likely to get in trouble and destroy at least part of its capital.
Another risky dividend is Resource Capital Corp. (RSO) – though there’s still a chance you’ll receive the distribution. RSO invests in commercial mortgages and pays a steady dividend of $0.20 per quarter for a yield of 17% at today’s price. Its dividend is uncovered by net income, but unlike mortgage real estate investment trusts (REITs), which have huge interest rate risk, its balance sheet is only moderately vulnerable to a rise in interest rates. RSO is also trading at 63% of book value, so there’s a solid backing if things go wrong. At the same time, you wouldn’t want to put your retirement funds in it.
A more equivocal case is Freeport-McMoRan Inc. (FCX). FCX had bought oil assets at an excessive price two years ago, but was gallantly paying out $1.25 per annum to give a yield of 6.8% on its current price of around $19.
Alas, last week, FCX cut its annual dividend to $0.20. The overall business continued to be profitable, but even a dividend yield of less than 7% proved unreliable. (The shares, on the other hand, have not dropped much further and may be a reasonable investment at these levels, depending on what precious metals and copper prices do.)
Perhaps the best combination of safety and yield I’ve seen recently is a transportation stock I mentioned a few weeks ago, TAL International Group (TAL). TAL is a container leasing company that yields 7.1%, with its dividend well covered by earnings. It’s an unglamorous, no-growth business with a generous management – the sweet spot for attractive dividend yields.
Yet even at just over 7%, such opportunities are few and far between. Early in this bull market, in 2009 to 2010, you could find plenty of yields in the 10% to 12% range that had a good chance of being sustained – but that’s no longer the case. Stock prices have risen too high, and income investors have combed through the listings.